December 13, 2010

Uncertainty and Taxes

A Fatal Policy Mix
Key materials
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The much-discussed Bush-era tax rates expire on December 31, 2010. Republicans have pushed for a permanent extension of all the current tax rates, while Democrats have pushed to make rates on the middle class—defined as individuals earning under $200,000 and married couples earning under $250,000—permanent and to let the existing rates on higher earners expire and return to a high of 39.6 percent. It now appears that the most likely compromise will be a temporary extension of all the tax rates, possibly for two years.

Kicking the tax reform can down the road introduces a new element into ongoing political discussions. At a time of growing concerns about issues including mounting federal deficits and entitlement reform, the consensus seems to be to extend the current tax code only until these problems can be fully addressed and then tackle tax reform. However, the environment of uncertainty that a temporary extension of the current tax rates imposes in the meantime will have disastrous consequences.

People do not like uncertainty, especially when it comes to their taxes. Uncertainty in the tax code leads to economic paralysis because, in such an environment, it does not make good business sense to hire and invest. Moreover, under uncertainty, individuals are fearful of spending and/or taking additional investment risk. Without that spending and investment, the economy will not return to full employment growth.

As this paper will show, tax reform is necessary. However, given our current tax structure, any increase in marginal income-tax rates will actually retard economic growth and stall recovery further. It is important for Congress to focus on implementing stable low marginal tax rates that do not discourage working, saving, or investing and provide taxpayers with some degree of certainty to make growth promoting economic decisions.